Puerto Rico Debt Gaining Popularity – As A Hedge

By Michael Aneiro

I’ve written recently about how Puerto Rico debt is finding favor among hedge funds rather than plain old buy-and-hold muni investors lately, as a way of cautioning retail investors tempted by Puerto Rico’s high yields about who else is roaming that marketplace. Today David Kotok, chairman and chief investment officer at Cumberland Advisors, offers an in-depth look at one way hedge funds might use Puerto Rico debt to their advantage:

My colleagues Michael Comes, John Mousseau, and I took apart a hedge fund trade. We reconstructed ways in which hedge funds can buy Puerto Rico and also hedge the other side of the trade for their profit. They can take long positions in Puerto Rico debt. They offset the risk through either a short position or put option on Assured Guarantee stock. Assured Guarantee is the major bond insurer of some Puerto Rico debt. Alternatively, the hedge fund can use a credit default swap on Assured Guarantee. In either case they try to neutralize their Puerto Rico default risk by using Assured as a proxy.

The theory behind this is that Assured Guarantee would be hurt if Puerto Rico defaults. So, the hedge fund’s long position would lose from a Puerto Rico debt downgrade or default, but it would have an offsetting gain from the credit default swap position or short position on Assured Guarantee stock. The offsetting neutralized position could result in a profit to the hedge fund. In fact, my colleagues and I calculated that the hedge fund could assume a neutral duration position and thereby create about 350 basis points in an annualized tax-free yield. That yield would also be a tax-free yield to the hedge fund’s investors. So the typical hedge fund investor can derive a taxable-equivalent yield of about double the tax-free yield, or about 7% on a maturity structure that can be unwound in only a few days. That is without leverage. My colleague John Mousseau noted that some hedge funds may be able to lever this up to 20 times.

There is still counterparty risk when putting such a trade together. And the position needs continuous rebalancing, since it has three or more moving parts and constantly adjusting weights. But that is exactly what a hedge fund is supposed to do. What we want to show is that there are ways to do it. Furthermore, note that the starting point of the trade is buying Puerto Rico debt, not because you like it but because it offers a hedging opportunity in a distressed market.

Kotok says that Cumberland does not hold any Puerto Rico debt “and we would not buy it today,” adding that the same is true for any mutual fund with exposure to Puerto Rico.